July Agency MBS Update

Monthly Commentary

The second half of 2018 opened with mortgages demonstrating strength, as
continued low volatility helped agency MBS erase nearly all of the year to date
underperformance. After a first quarter that saw agency MBS valuations struggle
behind higher volatility and sharply increasing interest rates, the second quarter
was characterized by quieter movement in mortgages. July was a story unto itself.
The agency MBS basis tightened most of the month, shrugging off concerns about
emerging markets and global central bank policy. Federal Reserve meeting minutes,
released at the beginning of the month, intimated that all reinvestments in agency
MBS may end before the year is out, marking the potential end of the largest
intervention in mortgage markets in history. Given the telegraphing and tapering
of purchases, the market is as prepared as it can be for the removal of government
support. However, due to the size and scope of the operation, it cannot be assumed
that no unintended consequences will materialize as the government attempts
to slowly wind down its agency MBS balance sheet. Late in July, quiet summer
markets gave way to news that the Bank of Japan may be changing their yield curve
management strategy, causing longer term U.S. Treasury rates to increase 10 basis
points (bps) over the month. Impressively, the increase in yields did little to stem
the tide of positive agency MBS performance. Mortgage rates are not far from where
they were just a few months ago, keeping prepayment concerns on the back burner
and further extension risk manageable. The lack of broad based concern over interest
rates in July bolstered agency MBS valuations, which further benefitted from a strong
month for global risk assets. Ultimately, the confluence of positive factors propelled
the agency MBS basis into solidly positive territory for the month. In aggregate, the
BloombergBarclaysMBS Index outperformed benchmark U.S. Treasuries by 20bps
in July, bringing year to date underperformance to just negative 4bps. Total returns
remain negative, with another slightly negative month sending year to date total
returns to negative 1.06%.

Performance was positive across the coupon stack in
July, as the strong month for the agency MBS basis lifted
valuations across the sector. Mildly higher interest rates
did not cause much in the way of extension fears, as lower
coupons performed in line with higher coupon collateral.
Fannie Mae 30yr (FNCL) 3s posted positive 18bps of excess
returns in July, with FNCL4s coming in up 18bps as well.
With the yield curve largely unchanged over the month,
and 10yr yields closing right around the levels seen in mid-
June, the coupon stack has gotten a welcome respite from
the kinds of interest rate volatility shocks that can wreak
havoc on valuations. While prepayment risk and further
extension risk remain muted for the time being, there have
been multiple interest-rate-volatility shocks over the past
few years, making it important for investors to be mindful of
unforeseen risks. Ginnie Mae (G2SF) collateral outperformed
conventional counterparts, with G2SF3s coming in +32bps
versus benchmark U.S. Treasuries, and G2SF4s finishing up
27bps. The outperformance was not surprising, as collateral
differences usually benefit Ginnie Mae valuations when
interest rates rise. Higher coupon Ginnie Mae collateral also
outperformed, as slower-than-expected prepayment speeds
in higher coupon Ginnie Mae securities caused G2/FN swaps
to appreciate. The G2/FN 4.5 swap finally moved into positive
territory, after years of trading negative. Regulatory efforts to
curb speeds in higher coupon Ginnie Mae collateral seem to
be paying dividends, as G2SF 4.5s and 5s peak prepayments
have slowed significantly recently. Ultimately, if speeds remain
slow, further regulatory efforts may not be necessary to keep
Ginnie Mae prepayments in check.

The effort to reign in prepayment speeds of military veteran
borrowers remains the key regulatory story of 2018. However
as prepayment speeds have come down over the past two
months, the story has retreated to the background for now.
However, Fannie Mae did announce that they will be creating
a new program for high LTV borrowers. Dubbed the Enterprise
Paid Mortgage Insurance Option, the program will allow high
LTV borrowers to get mortgage insurance by dealing directly
with Fannie Mae rather than having to work with a separate
mortgage insurance provider. The primary effect of this will
be a slight reduction of credit standards. Smaller servicers
will be able to provide higher LTV loans more easily, making
it easier for borrowers to take out loans with less equity and
more leverage. FreddieMac has a similar program, which has
resulted in a relatively small number of loans made through
it. Thus, this one program is unlikely to materially alter MBS
collateral characteristics. That being said, the continued
loosening of credit is an important trend to monitor as we
enter the final stages of the credit cycle.

The end of the credit cycle, while impossible to pinpoint in
advance, often comes with warning signals. The yield curve
provides the most famous of these warning indicators. When
short term interest rates trend higher than long term interest
rates, inverting the yield curve, it signals that near term
borrowing may be more risky than longer term borrowing.
Volatility generally falls in concert with the flattening curve, as
investors get lulled into a false sense of security right when
vigilance and caution are most needed. While the curve has
not yet inverted, and was largely unchanged in July, at mid month
it dipped to its lowest level since 2007. For agency
MBS investors, flat yield curves hinder the performance of
seasoned collateral since longer duration assets outperform
as the curve grinds toward inversion. While the yield curve is
not yet inverted, the spread between 10yr and 2yr U.S. Treasury
yields broke below 30bps briefly in July, signaling that we are
closer to the end of the flattening than we are to the beginning.
Therefore it is prudent for investors to be mindful of what the
end of the cycle might look like for the agency MBS universe.
Investors should be prepared for volatility to increase, but
should remain wary of the idea that agency MBS can be
fully eschewed, as other asset classes may react far more
grievously to the curtain closing on the current bull market.
Furthermore, even negative yield curves can persist for some
time. Therefore, it is imperative that agency MBS investors be
mindful that while the status quo may not be fleeting, a closing
curtain can open to a new act at any moment.